Trading stock options can be perplexing. Stocks are basically buying a piece of a company. Bonds are loans. Mutual funds are investments in companies that make investments. It’s all relatively simple stuff (well not really at all, but the basic concepts aren’t too difficult). Options, on the other hand, can be hard to understand even on a basic level. Many average investors shy away from options for this very reason. The fact that they have a reputation as a relatively risky investment doesn’t help either. But there is certainly money to be made (and of course lost) in options trading. One thing’s for sure: you’ll never know if options are for you if you don’t even know what they are, so here is a very, very basic overview.

You are probably at least somewhat familiar with the stock market. Well, there is an entirely different market that trades in derivatives. They are called derivatives because they derive their value from assets. In the case of options, which are derivatives, they commonly derive their value from stocks. In the options market, contracts are bought and sold based on the value of certain stocks. Options are contracts which give you the right, but not the obligation, to buy or sell an instrument (most likely stocks) at a certain price.

One common comparison used to explain options is a down payment on a car. You put some money down (which is nonrefundable) on a car so you can purchase it at a later date. You may find out that the car is indeed a good investment, so you purchase it at the discussed price at a later date. Or you may find out it is a lemon and you don’t purchase it, losing your deposit in the process but not wasting all of your money on the purchase.

Calls give the holder the right to buy an asset (stock) at a certain price within a specified period of time

Puts give the holder the right to sell an asset at a certain price within a specified period of time

You can be a buyer or seller of calls and a buyer or seller of puts. But selling calls and puts is more complicated, so we will focus on buying.

An investor will buy a call option contract if they think that, by the time the option contract expires, the stock price will rise above a set amount, called the strike price. If this happens, they win on this investment because the call contract allows them to purchase stock at the strike price, when the current price of the stock is higher. Therefore, they can purchase the stock at the lower price and turn around and sell it at the higher, going rate. This is called exercising.

Exercising is actually the least common outcome of an options contract. If the stock is above the strike price, the holder can also choose to sell the contract, which is called closing out their position. Since the price of the stock rose, the price of the contract also rose so they can just sell that at a profit.

If the stock price doesn’t reach the strike price in the allotted time period, the contract expires and the investor loses the investment.

An investor will buy a put option contract if they think the price of a stock will fall. Since the put contract allows them to sell an asset at the strike price, the put contract increases in value as the stock drops because the contract allows owners of the stock to sell for more than it is worth.

Example (with completely arbitrary figures):

A stock is $10 per share. A three-month call option contract is available for $1 per share. Since options are sold in bundles of 100, the total price of the option contract is $100. The strike price is $12.

So if the price of the stock reaches $13 per share before three months is up, they can exercise their option, purchase the stock at $12 per share and sell it for $13, breaking even (keep in mind the $100 spent on the option contract). If it rises to $14, they will make $100. Also remember that they can close out their position and sell the option contract itself, which would have also increased in value along with the stock. In real life, you would have to take commissions into account as well.

The advantages of trading in options include the ability to profit from a small change since they go by the 100s (a $1 increase in share price on $1,000 worth of stock won’t really make you much) and being able to profit from a declining market with puts.

The primary disadvantage is the risk involved. If your stock price drops, your assets may be worth less but not worthless because you still have something. If your option doesn’t reach the strike price, you lose that investment completely.

It’s not easy stuff, but options can be a good investment. There is so much more that can be said about options and the different ways investors can use them to their advantage. But hopefully now you at least have a general idea of what they are and how they work. Maybe you could even fake your way through a conversation with a snobby wannabe business intellectual by throwing out the terms “put” and “strike price.” No, don’t do that. But do look into options trading a little more if I have piqued your interest.

ABOUT THE AUTHORBenjamin Wey is a journalist and a Wall Street financier. A graduate of Columbia University, Benjamin Wey is a senior adviser to several government entities and businesses. Mr. Wey shares his thoughts about trading risks in the world of finance.